Why negative interest rates are doing more harm than good
As interest rates fall to zero or below banks become more reluctant to lend
With a small matter of US$12 trillion of bonds now trading at negative yields, our policymakers are left dumbfounded, like rabbits in the headlights, unable to do anything more than reduce interest rates to oblivion.
Just a short while ago, policymakers were talking of raising rates in the UK now, after Brexit, they are talking about lowering them. A particularly useless response, when rounds of cutting have merely served to debase the value of money, remove a major tool of economic management from their arsenal of weapons, and inbred bad financial behaviour. They have created a monster where money is cheap and plentiful and cheap but is stuck in big pools, moving sluggishly around the economy, like blood through hardened arteries.
Negative interest rates hurt the banks because their spare cash loses money when placed with central banks overnight. Rates are being kept low to encourage banks to lend but this is not happening because policymakers have created just too much cash. Big companies are cash rich and don’t need to borrow, and the risk of lending to small companies demands a much higher rate of return.
A bank is the ultimate example of a carry trade; simply where you lend for a long time at a 2-3 per cent spread, making good money - but at the risk of losing the whole 100 per cent of a loan if a borrower goes belly up. The banks need much higher lending rates to cover their bets to the smaller company sector.
Indeed, the banks are now so risk averse that new companies in Hong Kong can’t even open a bank account. I have been asked for three years of financial statements, the number of employees, and the status of the company’s MPF for a start-up. Of course, a new company doesn’t have these things – and a “no” generally means that you can’t open a bank account. Naturally the regulator, the Hong Kong Monetary Authority, has been silent about this dysfunctional element of our banking system.
This is dangerous for one dysfunctional element in the banking system usually portends another; it is the tip of the iceberg – a symptom of stress in the rest of the system. If the banks won’t lend to companies and individuals, they will get money from people who will.
The shadow banking system in China used to be seen as the product of a weak system – now it looks like sensible economics. Small corporates were unable to get money out of the regular banking system because lending rates were capped and the banks refused to lend to them. So they went elsewhere to those with money who were willing to lend it out at risk-covering rates – that were much higher. Even in developed markets today, leveraged lending can offer more than 5 per cent returns. The shadow lenders might be funded by sophisticated investors, willing to take the risk for much higher yields, or monolithic corporates. Apple, with its US$200 billion cash pile is probably a better risk to bank with than … er, a bank.
Recent reform has lessened the problem that Chinese banks had with lending but a two-tier system of banking still remains; the state-owned enterprise sector of low rates and low returns, and the private sector of high rates, high returns and high risk. In the West, the central banks have created low lending rates – fertile ground for shadow banking to emerge.
Why should banking regulators like the HKMA get involved? Because shadow banking is unregulated and those lending to the shadow banks have to be sophisticated enough to understand the risks they are taking with small companies and their bankers. Bank regulation is there because the banks can become too big to fail, until they do fail through stupid lending. The “little people” with their life savings need protection.
We seem to be on the cusp of the emergence of a two tiered lending system – a low interest rate business operated by traditional banks, and market-rate lending operated by an unregulated shadow banking sector. And if the traditional banks can’t lend at high rates, they may become the dull utilities they should be, like electricity and gas, surviving only to provide mere deposit and payment services. This might be healthy for the economy albeit a headache for regulators.
A dual lending system will make the Fed’s and the ECB’s manipulation of interest rates look silly, but of course they will have brought it on themselves. Perhaps a further example of banker incompetence.
Richard Harris is Chief Executive of Port Shelter Investment Management. www.portshelter.com